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How Madoff Is Burning the SEC

A 1992 probe should have raised red flags when new tips came in about Madoff. Now critics question the agency's ability to act as a watchdog

Bernard L. Madoff operated on the edge for years. But an early encounter with the Securities & Exchange Commission didn't raise red flags about the financier now accused of running a massive fraud. It's the type of missed opportunity that's further eroding investor confidence and prompting Congress to explore regulatory reforms.

The SEC's interest in Madoff goes back to at least 1992. That year the federal watchdog sanctioned three small firms raising money exclusively for Madoff. After investigating a confidential tip that one of the money managers was promising annual returns of up to 20%, the SEC shut them all down for selling unregistered shares. (Under federal rules any firm that sells securities to a U.S. investor must file certain documents first.)

Madoff, whose books were examined soon after by the SEC, was never sued by the regulator. But as part of a settlement, the firms, which neither admitted nor denied liability, had to repay investors. That forced Madoff to return the money they raised for him, some $454 million. "Somehow, he got it done over a weekend," says a person familiar with the firms.

It's not clear whether Madoff was already developing what authorities claim may be the biggest financial fraud ever—an alleged scam that collected money from new investors to pay off earlier ones. But that's just the sort of shenanigans regulators initially suspected they had uncovered in the 1992 probe: a Ponzi scheme perpetrated by the three firms. When investigators learned the money had been funneled to a Wall Street titan, Madoff, they became less concerned about outright fraud. After all, Madoff, a former chairman of the Nasdaq stock market, was a pioneer in electronic trading. The Madoff connection "was a good thing" for the firms, says a person close to the SEC investigation. "Nothing improper was found [in Madoff's books]."

In hindsight, the episode should have been remembered a decade later when regulators started receiving anonymous tips about potential improprieties at Madoff's operations; but the resulting inquiries yielded nothing significant. That they did not raises serious questions about the SEC's ability to combat and prevent fraud. "The commission doesn't seem to have pursued its enforcement mandate with enough vigor," says noted SEC historian Joel Seligman, president of the University of Rochester.

Digging Deeper

Congress will hold hearings in January to discuss why the SEC failed to uncover the Madoff mess. Critics say the SEC doesn't have the manpower or the systems to provide the necessary oversight. "The SEC needs more staffing in both its enforcement and examination divisions," says Ron Geffner, a former SEC staff attorney, now a lawyer at Sadis & Goldberg. "It needs to enact a process in which recidivists are reviewed with greater scrutiny." Madoff and the SEC declined to comment.

The 1992 investigation centered on Avellino & Bienes, a tiny New York accounting firm run by Frank Avellino and Michael Bienes. According to court filings, the duo started raising money from clients, friends, and relatives 30 years earlier, handing the cash over to Madoff to invest. By 1984, Avellino and Bienes had ditched their accounting practice altogether to focus exclusively on finding investors for Madoff. Avellino and Bienes didn't return calls.

The firm had its own "feeders," associates who rounded up cash that eventually made its way to Madoff. In 1989 accountants Steven Mendelow and Edward Glantz, whose office was on the same floor as Avellino & Bienes in a Manhattan office building, joined the game. According to the SEC's complaint, Mendelow and Glantz collected $89 million for Avellino & Bienes. Glantz's son Richard later started raising money as well. The party ended in 1992 when the SEC demanded in a settlement that the firms close up shop, reimburse $454 million to 3,200 investors, and pay a collective $875,000 fine. Edward Glantz has since passed away. Mendelow couldn't be reached.

Smaller Fish

Within a year or two of the SEC investigation, Madoff was accepting money from at least one player who didn't register shares with the SEC, according to a person familiar with the operation. In an effort to rebuild his investment practice after the probe, Madoff also dropped his minimum account size from $1 million to $50,000 for at least one feeder fund. As a result, less affluent investors gained entrée to Madoff's operation. That's one reason it's not just wealthy investors and institutions who are ensnared by the current scandal.

Rather than viewing Madoff as a scofflaw, regulators called on him for his expertise. Edwin Nordlinger, an SEC staffer involved in the Avellino & Bienes investigation, recalls accompanying a new SEC commissioner on a visit in the late '90s with Madoff, who schooled the regulator on over-the-counter markets. Arthur Levitt, chairman of the SEC from 1993-2001, has said publicly he consulted with Madoff during his tenure. Says Nordlinger: "Madoff was considered an expert."